PAYING ATTENTION TO THE RULES IS CRUCIAL

Apr 17, 2019

By Jeremy T. Rodriguez, JD
IRA Analyst

If the dictionary had pictures next to each word, the U.S. Tax Code would fit nicely next to the definition of “esoteric.” But as we all know, this complex web of rules and regulations cannot be ignored. Mistakes cost money, in the form of extra taxes, penalties, and interest. Some mistakes can be fixed, but not all. Even those that can be fixed may incur IRS user fees or, at the least, professional costs to unwind the transaction.

To avoid the consequences, you must clearly understand all the applicable rules. There’s an old saying: “close only counts with horseshoes and hand grenades.” That is indeed the case when it comes to complying with the tax code. So, while there are literally hundreds of mistakes someone could make with retirement plan money, I wanted to highlight some of the more common ones (not in any particular order). Keep in mind that some of the consequences could overlap, meaning the same mistake could cause two separate tax consequences to apply!

60-day Rollover Mistakes – Here, someone takes a distribution from their IRA or company retirement plan that is payable to them. They intend to roll the amount over within 60-days but miss the deadline. The distributed amount is now taxable and subject to the early distribution penalty. However, the individual could qualify for relief under the IRS Self-Certification Program or through a Private Letter Ruling (“PLR”). Just be aware that the Self-Certification Program is limited to certain mistakes and the PLR process is both costly and timely.

Direct Rollover Mistakes – Many taxpayers understand the pitfalls a 60-day rollover presents, and therefore wisely chose to directly roll over IRAs or qualified plans to another IRA or tax deferred account. However, not everything can be rolled over.

For example, Required Minimum Distributions (“RMDs”) cannot be rolled over. RMDs are considered the first amount distributed from an account. In an IRA-to-IRA transaction, this isn’t an issue; RMDs can be aggregated amongst IRAs. However, if we are talking about a company retirement plan-to-IRA transaction, it’s important that the RMD is distributed before executing a rollover. If ignored, and the entire account (including the RMD) is rolled over, the RMD becomes an excess contribution (explained below). Though we can fix this mistake, it may end up costing unnecessary taxes or penalties.

Prohibited Transaction – If forced at the tip of a bayonet to number these mistakes, prohibited transactions would earn top billing. Why? If you engage in a prohibited transaction, the entire account becomes taxable as of January 1st of the year the transaction occurred! Moreover, not only is the account now reportable and taxable for that year, but it loses any creditor protection it may have had. These consequences are about as steep as you can get.

Thankfully, for most this isn’t an issue. The vast majority of people invest IRA assets in an array of publicly traded stocks, bonds, and mutual funds. However, if you are utilizing a self-directed IRA and investing in real estate or business entities that you are involved with, you need to examine these rules carefully before engaging in the transaction. This is one of those mistakes that cannot be fixed.

Prohibited Investments – You can investment in several things within an IRA, but the tax code does have limits. IRAs cannot invest in antiques or collectibles (e.g., stamps, artwork, antiques, gems, rugs, baseball cards, etc.), hold life insurance, invest in many different types of coins (though there are exception to this prohibition), or engage in certain types of derivative trading. In addition to this list, you also need to review the IRA custodial document. Even if the investment is allowed under the tax code, it becomes a prohibited investment if it is excluded from the custodial agreement. A common example is real estate. The consequence of a prohibited investment is the value of the investment becomes taxable. Again, this is a mistake that cannot be fixed.

Missed RMDs – RMDs are minimum distributions that must be made each year once they begin. The start dates vary depending on the RMD recipient:i.e. the original IRA or company plan account owner, a spouse beneficiary, a non-spouse designated beneficiary, or a non-spouse non-designated beneficiary. And while the RMD calculation is largely the same (i.e., you divide the account balance as of 12/31 of the previous year by an appropriate life expectancy factor), there are differences amongst these different recipients. However, one thing is the same; the penalty for a missed RMD is 50% of the undistributed amount. Thankfully, the IRS can, and often does, grant relief for this type of mistake.

Excess Contributions – These are contributions which exceed any of the eligible contribution limits. (For 2019, IRA limits are $6,000 plus a $1,000 catch-up contribution for those age 50 and over). It also applies to ineligible amounts that are rolled over into an IRA, like the RMD discussed above. Any excess contribution is subject to annual 6% penalty. That means it continues to apply until corrected.

In addition to the ineligible rollover, another example includes an ineligible contribution. For example, if you contribute an amount to your IRA that exceeds the annual limit, the additional amount becomes an excess contribution. Additionally, the limit referenced above is lowered depending on your adjusted gross income (i.e., “phase-out limits”). The limit for Traditional IRAs is further adjusted depending on whether you, or your spouse, has access to a retirement plan at work.